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Cost-Push Inflation

Summary:
Inflationary pressures can originate from the demand side or the supply side of the economy. Demand-side inflation, known as demand-pull inflation, becomes increasingly likely as the economy nears full capacity. Inflation driven from the supply side, referred to as cost-push inflation, is possible in the absence of any excess demand for goods and services. A supply shock can cause one-off price hikes, independently of demand conditions, but for the one-off effect to act as a catalyst for cost-push inflation there needs to be a socioeconomic process capable of reinforcing the initial effect and a pliant institutional setting. The most likely candidate is ongoing conflict over the distribution of income, expressed through workers’ wage demands and/or firms’ price-making behavior, with

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Inflationary pressures can originate from the demand side or the supply side of the economy. Demand-side inflation, known as demand-pull inflation, becomes increasingly likely as the economy nears full capacity. Inflation driven from the supply side, referred to as cost-push inflation, is possible in the absence of any excess demand for goods and services.

A supply shock can cause one-off price hikes, independently of demand conditions, but for the one-off effect to act as a catalyst for cost-push inflation there needs to be a socioeconomic process capable of reinforcing the initial effect and a pliant institutional setting. The most likely candidate is ongoing conflict over the distribution of income, expressed through workers’ wage demands and/or firms’ price-making behavior, with endogenous credit accommodating the wage and price movements in nominal terms.

Conflict over distribution is likely to intensify when supply-side events impact negatively on aggregate income, potentially setting off a wage-price spiral in which workers and firms attempt to protect their real incomes. The oil shocks of the 1970s are an often cited historical example.

In recent decades, with organized labor weak and social protections eroded, the negative consequences of supply shocks are likely to be borne disproportionately by workers and the poor, who currently have little capacity to win improvements in pay, conditions or entitlements.

A possible impetus for cost-push inflation, under present circumstances, might be rent-seeking in the provision of essential services (such as in water, electricity, gas, communications, transportation, education and health) as well as in finance, insurance and real estate, through incremental raising of fees without concomitant improvements in service quality. When, for given service quality, fees rise faster than economy-wide productivity, an upward bias on prices is imparted from the supply side.

Whatever the likely driver of supply-side price pressures, the basic theoretical aspects of cost-push inflation can be understood.

 
A simple depiction of supply-side price pressures

Theoretically, for given levels of demand and average productivity, a one-off supply shock can occur through:

  • an increase in the average money wage;
  • an increase in firms’ pricing markups over costs of production;
  • an increase in prices of imported inputs (perhaps caused by exchange-rate effects or a constriction of supply chains due to war, pestilence or extreme weather);
  • an increase in taxes on production or consumption.

The first two causes presuppose a degree of price-setting power on the part of workers or firms.

The influence of wage and price-setting behavior can be considered starting from the national accounting identity

Cost-Push Inflation

where Q and Y are output and income, respectively, both measured at constant prices, and P is an index of the price level. This identity simply says that nominal output equals nominal income by definition.

Since nominal income is composed of total money wages, W, and aggregate monetary profits, U,

Cost-Push Inflation

Here, (W + U) / W is one plus the average markup over money wages (i.e. 1+U/W). Denoting one plus the markup as k,

Cost-Push Inflation

Dividing both sides by the level of employment, L,

Cost-Push Inflation

In this expression, Q/L is average productivity, y, while W/L is the average money wage, w, paid per unit of employment. So,

Cost-Push Inflation

Rearranging,

Cost-Push Inflation

or, expressed in rates of change,

Cost-Push Inflation

This final expression says that the price level will rise if the combined growth of firms’ average markup and workers’ average money wage exceeds the growth of average productivity. Put the other way round, the markup and money wages can grow alongside stable prices so long as this growth is matched by improvements in average productivity.

 
The potential for cost-push inflation

When the sum of workers’ wage demands and firms’ profit aspirations exceed current nominal income (PY), an increase in prices resolves the otherwise incompatible income claims in nominal terms (by increasing P for a given Y, and therefore increasing PY). In real terms, however, both groups fail to realize their aspirations, and so each group may continue efforts to gain real income at the expense of the other. In this way, the conflict over distribution is likely to be ongoing and, if enabled by the credit system, have persistent inflationary effects.

With the capacity of workers to drive such a process through their demands over pay and conditions severely curtailed in recent times, the likelihood of a wage-price spiral and rapid cost-push inflation seems low. More likely, in the present environment, might be a slow grind in which monopolistic or semi-monopolistic corporations catering to captive consumers of essential utilities and other services, along with rent seekers in finance, insurance and real estate, effect a creeping escalation of service fees in excess of average-productivity growth, gradually elevating the economy’s nominal cost structure. Depending on wages and developments in other sectors, this can translate into a continually rising price level.

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